Talking with married clients about what happens if one of them dies is one of the most difficult conversations we have as financial advisors to thriving retirees. But there’s an even more difficult conversation that we sometimes have to face: explaining to a recently bereaved spouse why their tax bill is so much higher, now that their loved one has passed away.
This scenario happens all too often. First of all, the now-single surviving spouse is no longer eligible for “married, filing jointly”; instead they must file as a single taxpayer. Among other things, this means that their personal exemptions are cut in half. Also, because most thriving retirees have done such a good job of contributing to IRAs, 401Ks, and other qualified retirement plans during their working years, the surviving spouse, who is typically the beneficiary of those plans, is still required to take required minimum distributions (RMDs) each year, starting at age 72. Often they will be receiving virtually the same amount of income as a single taxpayer as they were when part of a married couple—but may now owe more taxes because of fewer exemptions and perhaps even being in a higher tax bracket. In addition, because the surviving spouse may elect to receive the deceased spouse’s Social Security benefit if it is more than they can receive on their own, they may be in the position of having to pay taxes on a larger percentage of Social Security income, because single taxpayers reach the higher tax thresholds for Social Security benefits sooner than married taxpayers.
Fortunately, with some planning ahead while both spouses are living, the effects of the “widow’s tax trap” can be mitigated, if not avoided altogether. By carefully considering the order in which funds earmarked for retirement are utilized, and by shifting income from future-taxable to future-tax-free, some of the worst consequences can be eased.
First, it may be advisable for retiring couples to “spend down” non-tax-qualified funds. Paying capital gains on appreciated investments may be smart, both because capital gains are generally taxed at a lower rate than ordinary income, and also because married couples will generally be in a lower capital gains tax bracket than single individuals. This may be a case where it makes more sense to “pay now” than to “pay later.”
Also, retiring couples should consider converting traditional IRA and 401K accounts to Roth accounts. While this will require paying taxes on the converted amount now—which may hurt a bit—it will transform the future income drawn from the account to tax-free income. Also, because Roth accounts have no RMDs, the surviving spouse has the flexibility to leave the assets in the account if they aren’t needed for current income. If they are needed, they typically won’t affect the taxability of Social Security benefits.
As a fiduciary financial advisor, Empyrion Wealth Management specializes in working with thriving retirees and those preparing for retirement to make informed, tax-efficient decisions as part of their financial strategy. To learn more, click here to read our “Financial Planning Checklist for Retirement.”
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